Getting started

Student loan interest rates on the way up

January 22, 2006|By Carolyn Bigda

Federal student loans are about to receive a makeover, and at first blush the changes don't look good.

The Senate approved $12.7 billion in cuts to student aid at the end of 2005, as part of broader legislation to rein in federal spending. If passed by the House, as expected, the tightening would take effect as early as July.

There's no reason to think, though, that your financial aid will dry up next year. The days of rock-bottom interest rates are over, but the new proposals could broaden your funding options.

Where you'll pay

When the variable interest rate on Stafford loans hit 3.37 percent in 2004, the federal government had to bridge lenders' guaranteed yields, as high as 9.5 percent. As a result, the pending bill reduces lender subsidies and upholds a scheduled change to fixed rates: 6.8 percent for Stafford loans and 8.5 percent for PLUS loans (borrowed by parents). The new rates would apply only to loans made on or after July 1, when rates traditionally are reset.

With variable rates on the rise, the fixed rate could be competitive. Sallie Mae, a major student lender, projects Stafford loans will be reset to 6.55 percent this summer, up from 5.3 percent now (variable rates are capped at 8.25 percent).

But should variable rates eventually decline, fixed-rate borrowers could be left paying thousands of dollars more in interest.

Another change: The fixed rate applies while you're in school, the six-month grace period and deferment. Currently, Stafford borrowers enjoy a 60-basis point reduction at those times.

Then there's consolidation loans. While hordes of borrowers rushed to lock in low rates with consolidation loans in recent years, the fixed rate would eliminate that advantage for new borrowers.

Existing borrowers take note: The interest rate on consolidation loans still would be calculated by taking the weighted average of all your loans' interest rates, rounding up to the nearest one-eighth percentage point. Thus, if you have variable-rate loans, you wouldn't necessarily lock in the 6.8 percent rate.

Also, the bill does away with consolidation between spouses, as well as consolidation while you're in school.

"If students have a large enough balance to consolidate now, then they might want to do so," said Cheryl Watson, a representative for Nelnet Inc., a student loan lender. "But they do give up their grace period."

Where you'll benefit

Other proposals would have more definite benefits for borrowers:

- Reduced fees. Origination fees that typically are deducted when loans are disbursed would drop this year to 2 percent from 3 percent and gradually phase out by 2010 (a 1 percent guarantee fee would remain).

- Meatier loans. To keep pace with escalating tuition costs, annual limits on some loans would increase starting July 2007. First-year loans (both subsidized and unsubsidized) would jump to $3,500 from $2,625, and second-year loans to $4,500 from $3,500.

Subsidized loans for graduate students also would receive a boost, going to $12,000 from $10,000 a year.

- More funding options. After maximizing federal aid, grad students often turn to private loans to cover any outstanding costs. The bill would provide an alternative: the option to take out PLUS loans, typically limited to parents.

PLUS loans may be borrowed up to the total cost of education (minus other aid). And as a federal loan, it offers more appealing terms than private lending, such as no credit checks and the option to extend repayment.

Beyond loans, students studying math, science or certain foreign languages and who qualify for Pell grants also will be eligible for new SMART grants, up to an additional $4,000 per year.

Looking ahead

In addition to subsidy cuts, the guaranteed reimbursement rate to lenders on unpaid loans will be lowered. As a result, industry experts say, some lenders may be pushed out of the market or forced to scale back borrower benefits, such as interest rate cuts when you pay on time.

But right now that's all speculation. Instead, fill out your financial aid form and focus on how you'll stretch your student loan dollars.